investment viewpoints
Passive equities have never been so concentrated: can active managers provide diversification?
US and global stock indices are more concentrated than at any point in the past 30 years, and capital continues to flow relentlessly into passive strategies. With equity markets showing signs of extreme valuation anomalies, are investors focusing on passive strategies – which are, paradoxically, becoming increasingly concentrated – missing attractive opportunities that current market dynamics offer?
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A diversification paradox?
Market leadership in equity indices has been hotly debated this year. By the end of October, the ‘magnificent seven’ US mega-cap tech stocks had reached a combined market capitalisation of about 18% in the MSCI World and drove about 80% of the total return of the developed-world equity market. This raises an important question: is the equity market now so concentrated that it lacks, paradoxically, diversification?
Measuring concentration
One useful way to measure the diversification of a portfolio is to calculate the number of its effective stocks, and this method can also be applied to an index. Intuitively, with about 1500 companies, the MSCI World would seem highly diversified. Unfortunately, this tally is misleading: what matters more is how each stock is weighted.
The Herfindahl-Hirschman measure – sum of the squares of the weights in a portfolio – is a simple measure that helps assess true concentration. By inverting this measure, the effective number of stocks of a portfolio can be calculated. To illustrate this approach, let’s compare three conceptual portfolios:
- Portfolio A: five stocks, all equally weighted
- Portfolio B: five stocks, with one weighted 90% and the balance equally split across the rest
- Portfolio C: 10 stocks, with the same weighting approach as portfolio B
Applying the Herfindhal-Hirschman measure to these theoretical portfiolios, we find that A would be the most diversified, while B and C would have similarly low levels of diversification despite having different numbers of stocks.
FIG 1. Concentrations of three conceptual portfolios using the Herfindhal-Hirschman measure
| Portfolio A | Portfolio B | Portfolio C | |
| Number of stocks | 5 | 5 | 10 |
| Weighting approach | Equal weightings for all stocks | 90% in one stock and equal weightings for the rest | 90% in one stock and equal weightings for the rest |
| Herfindhal-Hirschman measure
| 5*(20%)^2 = 0.2 | 1*(90%)^2+4*(2.5%)^2 = 0.8125 | 1*(90%)^2+9*(1.11%)^2 = 0.8111 |
| Effective number of stocks | 1/0.2 = 5 | 1/0.8125 = 1.231 | 1/0.8111 = 1.233 |
Source: LOIM as at November 2023. For illustrative purposes only.
The same approach can be applied to key equity indices – for the US, Europe, Japan and global developed markets – in order to calculate their respective levels of concentration. Given the different number of companies in each market, for each index we have calculated the number of effective stocks and divided it by the total number of constituents in order to make the analysis comparable across regions and time.
The results are striking. We highlight two key findings:
- US equity-market concentration is at a three-decade high. In the MSCI USA Index, the number of effective stocks is about 10%, or 60 companies. This is the lowest level since the 1990 (see figure 2).
- US concentration has reduced diversification in the global equity index. Given the increased weightings of in US equities in the MSCI World – from about 30% in the early 1990s to 70% today – greater concentration in the US market has significantly driven down diversification in the global equity index. Worldwide, only 10% of stocks – or 150 companies – are now effective.
FIG 2. Effective stocks in the US, Europe, Japan and global equity indices
Source: LOIM calculations at November 2023. For illustrative purposes only.
Market concentration: a key dynamic for active vs passive investment
Given this concentration phenomenon, are conditions especially favourable for active managers? In recent years, as the market became increasingly concentrated, the equal-weighted index has tended to underperform its market-capitalisation-weighted counterpart. Such situations, where market performance narrows considerably, are usually difficult for active managers.
Research by S&P Dow Jones Indices, focused on the performance of the S&P 500 Equal Weight Index, suggests the inverse is also true. It found that, on average over the past two decades, “the more the S&P 500 Equal Weight Index historically outperformed the S&P 500, the more actively managed funds outperformed the S&P 500”. As such, active funds “might be expected to benefit” during periods when equal-weight indices outperform market-cap-weighted indices.
We may now have reached a tipping point. When concentration becomes extreme and stabilises, an equal-weighted index can then start to outperform – as in the early-to-mid- 2000s (see figure 3).
FIG 3. Relative performance of the S&P500 equal-weighted and market-capitalisation-weighted indices, compared with the percentage of effective stocks
Source: LOIM calculations at November 2023. For illustrative purposes only.
In recent years, passive equity fund managers have attracted more asset flows than active managers – a trend that is particularly evident in the US (see figure 4). It can be debated whether this has increased stock-market concentration or if the reverse is true, but this would not change a key outcome: because equity exposures are concentrated on a historically low number of effective stocks, a growing number of investors are now not as diversified as they might think they are.
FIG 4. US equity fund assets: active vs passive
Source: Morningstar Direct as at November 2023. For illustrative purposes only.
Extreme concentration is creating opportunities
Not only should equity investors – especially those in passive strategies – question how diversified their allocations really are, but also how well they are exposed to opportunities outside the small number of effective stocks.
More than in early 2000, markets today show an extreme level of valuation dispersion across the GICS industry sectors. Such dispersion is also visible across market-capitalisation ranges, with all companies sized under USD 100 billion at cheap valuations on a historical basis (see figures 5 and 6). A clear takeaway is that equity portfolios based on increasingly concentrated passive strategies could potentially miss out on these excessive valuation anomalies across both industry sectors and the market-cap spectrum.
FIG 5. Monthly standard deviation of GICS Industries’ price-to-book ratios (MSCI World Index), 12-month rolling average
Source: LOIM calculations at November 2023. For illustrative purposes only.
FIG 6. Price-to-book historical premium/discount by market cap ranges (MSCI World Index)
Source: LOIM calculations at November 2023. For illustrative purposes only.
Change will come
What kind of macro situation typically leads to a reduction – or even reversal – of this outperformance by concentrated indices? Figure 7 compares the average relative performance of the equal-weighted and market-cap-weighted S&P 500 indices across four types of US environments: recession, inflation, surprise interest-rate hikes and growth1. The analysis is based on data from 1990 to 2020 and, as such, excludes the recent tightening cycle.
FIG 7. Average annualised excess performance: equally weighted vs. market cap weighted S&P500 index during different macro regimes (1990-2020)
Source: Bloomberg, LOIM at November 2023.
This analysis shows how the equal-weighted index has tended to underperform throughout tightening cycles in the past three decades, and which also seems to be the case today. But it has typically produced annualised outperformance of 3.5% during recessions and almost 2% in times of growth over the same period.
As the Fed brings its tightening cycle to an end, conjecture remains about whether a hard or soft landing lies ahead. Irrespective of whether the economy enters recession or a mild slowdown followed by growth, the prospects for the equal-weighted index – and active managers – have improved recently, in our view.
sources.
1 gathering the rest of the historical dates
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